Theory of Relativity

October 15, 2002

After a more or less flat August, the market continued its long, painful downward spiral in September, with the Dow, NASDAQ, and S&P500 each down just over 10%. While everyone is now beating the bond drum twice as loud, it's worth noting only treasury bonds are doing particularly well right now, up around 4% for the month.

In the last issue of MAXadvisor we explained why treasury bonds may start being less of a sure thing, and might even surprise investors by their lousy returns as rates go back up sometime in the future (how's that for a prediction that can't go wrong?). 

This month I want to get back to the issue on everyone's mind: stocks. Namely, are stocks cheap, and can investors expect to make any money in them anytime soon?

As we've said for years now, to the point where we've been accused of being a permanent bear by more than one reader, stocks are expensive by historical measures. Why do we invest so much of the model portfolios in stock funds then? 

Several reasons. One is that stocks have been expensive by historical standards for most of the last 15 or so years, and we can't just sit in cash waiting for stocks to revert to some sort of historically appropriate value. Another is that it doesn't really matter how cheap stocks where 20 years ago; it matters how cheap they are now relative to other investments.

In fact, not to discredit years of bearishness on our part as being analytically questionable, but there is no absolute value for stocks that is right or wrong. We'd go as far as to say there is no absolute value for most things. Everything is relative to what is around you.

This may sound a bit like some hippy-dippy philosophy class in college, but lets think about it for a moment. When it's cold outside, it really is only because normally it is a bit warmer, when something is "pretty", it's only relative to the general ugliness that abounds. This is why you can't say you are rich if you live in New York City and earn $75,000 a year. You are rich compared to the median income of the country, but that is like comparing your wealth to the median income in Burma. The fact is, you have to spend your money on things like $2,000 studio apartments, $400 per month parking spaces, and $8 turkey sandwiches. You are by no means rich, relatively speaking.

Well, investing is very similar. All major investments offer some sort of return, either current of hoped for, on your money. That yield is generally how you value those investments. The relative risk in that yield sets the price of the investment - you generally pay less for investments that have the potential (risk) to disappoint in the future. 

"Major investments" include stocks, bonds, cash (money markets), real estate, and even bank CDs. We don't count things like collectibles and antiques as they don't produce income now or in the future, and are based on an investor's ability to value what someone will pay for the non income-producing asset in the future. This is not to say a Picasso at $5,000 is not a good value, just that this type of investing is generally difficult and, sensational stories aside that you may hear about some comic book being purchased for $1 and being worth $25,000, delivers disappointing long term returns to the average investor.

Stocks, bonds, cash, and real estate can deliver income. Stocks are generally purchased for the company's future earnings stream. Bonds pay regular fixed coupons, unless they default. Houses can be rented for income. While there is almost always a place for all these investment categories in most investor's portfolios, based on personal risk profiles and other factors, investors generally want to favor the asset classes that are cheapest relative to the others. So which is cheapest?

Cash today yields 1.5%. That is less than inflation. After taxes, cash holders are losing money each year. It is, however, very safe. Cash won't lose money. Real estate seems like the latest way to get rich. Since we are on the heals of 50% plus increases in real estate prices in certain areas of the country over the last 3 years while stocks have been decimated it's easy to see the attraction. Books about real estate speculating and flipping are now top sellers, replacing guides to new economy riches and prognostications for Dow 36,000, Wall Street Money Machines and other late 90's investment inanities. 

Without going into detail about real estate, or making predictions for a giant collapse in prices, you have to think that the likelihood of making more heady gains in real estate over the next 5 - 10 years from these levels are slim. Why? Because we're reaching a point where few new people entering the market can afford to buy a house, so unless mortgage rates go to 2%, something has got to give. 

Bonds have done very well these last few years, but that's because bonds were cheaper a few years ago. Now they are more expensive.

How is a bond more expensive? A safe government bond used to yield 6%. If you bought such a bond, you just made an investment in a safe security that has a P/E ratio of less than 17. Aren't PE's only used for stocks? 

P/E ratios are really nothing more than a relationship between the price and the earnings. Well, if you buy a bond for $1000 and it "earns" $60 per year (6% yield) you paid 16.6 times earnings for the bond. At around the same time, an investor putting $1000 into the S&P500 was "buying" about $30 in future income, since the S&P500 had a forward P/E over 30. Of course, stocks earn more and more money into the future (or so the story goes) so you pay more today for that growth.

Sadly, as it turned out, this was not simply a high price in relative terms. It was sky high, way out of whack, because earnings fell sharply, and, even more discouraging, were mere fabrications in many cases. For the record, there was once a time when stocks traded at lower P/E's than bonds because of the risk such nonsense like we've seen these last few years could happen. Somewhere in the speculative fervor of the late nineties, that detail was lost.

At the end of September the 10-year Treasury bond (technically a note) yielded just over 3.5%, almost half what it used to. Now when you put $1000 "to work" (Wall Street loves expressions like that) in treasuries you get $35 in income, or a P/E of 28. The S&P 500, which is down about 50% from its highs, probably will yield about $50 in income on a $1,000 investment in a year or so, adjusting for all the negative (and flat out bogus) earnings we're experiencing right now. That works out to a P/E ratio of 20.

A 20 PE is historically high, but pretty darn good compared to safe Treasury bonds. In fact, if the likelihood of an investment in stocks at these levels underperforming safe bonds (or cash) over the next 5 - 10 years is about as slim as it has ever been in history. As a sign of how insane stock prices where a few years ago, it took a 50% drop in stock prices (which means a doubling in yields from earnings normally) and a near 50% cut in bond yields for us to be able to make this prediction for the future.

And while we're predicting things, how will an investor do in these asset classes over the next say 5 - 10 years? From these levels, we'd expect US stocks (broadly speaking) to deliver about 4-7% per year over the next decade, partially from the 2% dividend yields many stocks now pay because of the recent stock price declines, and the rest from earnings and stock price growth. Pretty crummy, huh? Well, a portfolio of safe treasury bonds should yield less than 4% (and quite possibly much less in the near term if rates rise). Cash should pull in around 2 - 3%, and real estate may be dead last with flat returns over the next 10 years. You may even lose money in some formerly hot areas of the real estate bubble - er, market.

And this is why stocks need to play a part in your portfolio, because they are at current prices the best game in town. With intelligent diversification into out-of-favor areas and allocations to-better-than-average stock and bond funds with lower fees, you can likely add a few percentage points to this anemic forecast. 

Not that this relative argument will always save you. For one, all assets can decline from here (except cash). Two, in the short-term stocks are always riskier than bonds and real estate. Just look at the wild swings each day, particularly in a volatile month like October is shaping up to be. In fact, short-term behavior can often mislead you into bad investment decisions.

Five years ago bonds offered a yield of near 6%. Stocks were fairly expensive comparatively. However, the next couple years seemed to prove relative value is of no value - stocks rocketed up and bonds delivered ho hum returns. Only today, with stock prices back to where they were 5 years ago, with the fact that a portfolio of bonds, or real estate, would have outperformed stocks over those 5 years, do we see the error in ignoring the cheapest asset classes.

These low estimates shouldn't discourage you as an investor. Yes, assets and investments in general are expensive today and everybody won't get rich simply by purchasing some stocks and a house and those just starting out will probably have to save more than the last generation did to get anywhere financially. But you may not seem poor in the future, even with single digit returns on your investments. Why? Because things like houses and cars and college tuition and vacations and other things that you ultimately spend your money on won't go up as fast if everybody is earning less in stocks and bonds. In fact, a 4% return per year for a decade is fabulous if the price of everything remains the same - you'll be almost 50% richer feeling relative to today!